Behavioural Finance: its pitfalls for Investors

Behavioural Finance is the study of rational/ irrational behaviour of individuals which influences market prices, returns and allocation of resources. It attempts to understand how people forget fundamentals and make investments based on emotions.
The primary objective of all investments is to maximize returns and create wealth. Observing the behaviour of individuals leads us to believe that people are very often ruled by emotion (greed and fear) rather than by logic. They display imperfect rules of thumb (heuristics) to process the available data, thus bringing in individual biases in their beliefs, leading to commitment of fatal errors of judgement.

The important heuristics driven biases are:

• Representativeness – Forming an opinion of future action based on past performance. Investors may tend to rely on certain patterns in the past data that are random.
• Overconfidence – The human mind is trained to extract the maximum information from the available data, but it may not be adequate to arrive at an accurate forecast in uncertain market conditions. This phenomenon is described as ‘self-attribution bias’, where people tend to attribute their success to their investment skill and their failure to bad luck.
• Anchoring – Conservatism or the inability to change an opinion after subscribing to a fixed idea, often manifests in a failure to react to a new information which is relevant to one’s investment but does not match with his/her subscribed opinion.
• Innumeracy – This results from ‘mathematical illiteracy’ where people tend to misunderstand the statistical data. Generally, people tend to give more importance to big numbers and tend to overlook small figures.

Investors often fall prey to their own and sometimes others’ mistakes due to the use of extreme emotions in ‘Financial decision making’. If you compare the overall profits of traders, you will find that they make similar profits as long term investors. This is because they tend to pay huge fees such as brokerage, transaction charges, short term capital gains. You as a long term investor may be able to earn a higher return, in addition to the peace of mind.

So, the next time if one of your friend suggests a great investment opportunity, naming a ‘ten bagger’ or a ‘multi bagger’, just ignore it. When the market has crashed, the same set of people will create a panic by telling you to sell, just hold your emotions. Do not get carried away by extreme sentiments, because they bias your judgement and can only help you to make blunders. Have firm faith in yourself, and make your investments based on confirmed information and objective analysis of the same.
Remember: Money cannot buy happiness, but the lack of money can buy a lot of misery.

Inflation Effect: Is this the end of the India Growth story?

Week after week the inflation data is causing tremors in the markets. For week ending May 3, 2008, it has risen to 7.83%, a level not seen since 2004. How does it auger for the Indian economy? Inflation indeces comprise of 3 broad catagories: Agricultural output, Metals and Energy (Oil & Gas). Today analysts are pointing towards continuation of higher inflation, due to higher demand from the developing world, including India and China. The way things stand today, inflation is driven by high level of speculation in the 'commodity markets', a bubble which is waiting to burst. In the developed world, commodity prices have hit new highs recently as a lot of hot money has been diverted to the commodity markets, from other markets. Even pension funds have been investing higher proportion of their funds in commodities as a diversification tool. Let us analyse the movement of prices in India in the next 3-6 months:

• Agriculture: Foodgrain prices in India have started to ccol off with the bumper wheat harvest. World over foodgrain prices have softened recently. With the likelihood of normal monsoon prediction for the year in India, foodgrain prices are likely to remain soft over the next 2 quarters. The impact of this will be evident in the inflation indeces within the next 2 weeks.
• Metals: The slowdown in demand is starting to show its impact on prices of select metals. Gold is down almost 15% from its peak, and Nickle prices have cracked almost 50% from their peek. Iron ore prices are also showing signs of weakness. Cement prices in India historically have been low in the monsoon months, the impact of which will be seen after the onset of monsoon by the end of this month. Cement producres have been smart enough to reduce the prices of a bag of cement upto Rs.7 foreseeing a slump in demand.
• Energy: The only cause for concern remains the high crude oil prices. With the energy demand from the western world continiuing unabated, crude prices have continued their upward march. Speculation in the commodity futures is responsible for this trend. Indian economy is facing a double whammy: high crude prices accompanied by the slipping Rupee is causing a huge outflow of funds, putting pressure on the inflation indeces. Oil should peek out somewhere around the 130 $/ barrel mark soon.

Our stock markets have shown tremendous resilience, despite the negative inflation data, and flagging IIP numbers. In the short to medium term the markets have the potential to move upto 10 % from these levels, which will be an opportune time to book partial profits. The first quarter results for India Inc. may provide a slight negative bias, forcing the markets to react negatively. But a normal monsoon will help in easing the inflationary pressures by the second quarter of this fiscal.

Market Direction: Important triggers

Efficient Market theory advocates that human beings behave rationally and the markets always behave efficiently. But this is not true most of the times. Human beings rarely behave rationally as a group. The markets always look for market triggers: positive or negative to find their direction, in the short term. Let us find out what are the triggers for the market at this juncture:

• Results for FY 07-08: Currently the results are playing a major role in deciding the immediate course of the markets. As the results of majority of the companies have been better than expectations, markets have moved up about 20% from their March lows. This also is the time for portfolio churning based on the annual returns of the companies.
• Progress of Monsoon: Indian economy is very much dependent upon the monsoon. The markets will start discounting the progress of monsoon from the end of May. The predictions by the IMD are for a normal monsoon this year, if it holds good than the stock market will have a sustained rally in the months to come.
• Inflation: The government is doing everything to contain inflation, but the results have not been reflected in the inflation data so far, which continues to be a source of worry for the markets. Although the foodgrain prices have started to soften, the prices of crude oil and basic commodities like steel and cement continue to rise globally and the govt. can do very little in this regard. The artificial reduction in prices through force will only worsen the situation, unless supply concerns are met.
• Exchange Rate: The Rupee have depreciated against most currencies in the recent past and has recently breached the Rs41/ dollar mark recently. With crude oil ruling at all time highs of over 120$/ barrel mark, it does not auger well for the Indian economy as we are a large net importer of petroleum products. This will put a lot of pressure on our budgetary deficit and fuel inflation. But it augers well for certain sectors like oil exploration and refineries as their margins would improve. But public sector companies will continue to bleed because of faulty pricing mechanism followed by the govt.

Overall the markets have been resilient despite the negatives, and are currently consolidating above the 17000 level on BSE and 5000 on the NIFTY. In the absence of any major negative news, the medium term trend for the markets is up. But partial profit booking is advisable in the range 18200-18500 on the sensex and 5400-5450 on the NIFTY.